We had to burn the village to save it

The title of this diary is a quote from the Vietnam era that sums up for many the arrogance and pointlessness of American aggression in Asia two generations ago. It keeps coming to mind each time I read President Bush’s (paraphrased) statement this week: We had to nationalise the banks “to preserve the free market.”

There is no free market when the government owns the actors and sets the terms of transactions. There is no village once it has been burned to the ground.

The collapse of the financial sector is unacceptable. It is unacceptable to bankers who have vested careers, status and equity wealth in the disproportionate expansion of the financial sector. It is unacceptable to politicians who have risen to high office doing the bidding of the financial sector in ceding progressively more generous taxpayer subsidy and regulatory forbearance to its chieftains.

And so in the US, UK and EU we have politicians appropriating more petrol to hand to the arsonists who started the conflagration which is consuming our economic and political fabric. The regulators whose forbearance is a root cause of the current conflagration are handing the arsonists fresh zippo lighters. The policies adopted in these debtor nations will fail, must fail, because they destroy what remained of market economies. In the meanwhile, however, the bankers and the politicians and the regulators cannot conceive of failure and so insist on more of the same – ordering hundreds of billions in more incendiaries to fuel the blaze. The same tax breaks. The same housing subsidies. The same regulatory forbearance. The same ill-transparent, off balance sheet, accounting sleight of hand. The same eradication of market incentives to productive, disciplined saving, investment and labour.

Those who would prudently save will be punished with negative real interest rates and asset deflation. Those who would prudently invest in productive industry will be starved of scarce capital and forced into liquidation. Those who would prudently labour for a decent wage will be slowly robbed by inflation and kept docile by the threat of unemployment.

There can be no more iniquitous alliance than to have the politicians at the service of the bankers, unless perhaps it is to have the military at the service of the bankers too. The US seems to have committed itself to this worst of all possible combinations, with Congressmen threatened by the imposition of martial law if they failed to acquiesce to the Paulson Plan. Thankfully the British and EU militaries are too small and ineffective to be leveraged into a similar threat to global or domestic peace and security.

Subsidised banking seems a faster method of going bust than military adventurism, but the two together will see the US bust even more certainly. The $700 billion appropriated for the Paulson Plan and the $840 billion extended in parallel by the Federal Reserve last month are together more than three times the expenditure on US wars for the past five years. The federal borrowing requirement for 2008 is now in excess of $1.02 trillion, and for 2009 is now estimated between $1.5 and $2 trillion.

Such hyperbolic growth in the fiscal deficit and debt is unsustainable, even with such very tolerant creditors as the Japanese, Gulf Arabs, Russians and Chinese. They can see that each dollar added to the Fed’s balance sheet is tinder for burning those already held or denominated in their reserves. They can project the curve forward. At some point, they must react and restrain further debasement of their reserves and investments, either by collectively raising the prices charged for the resources and products they export, the interest charged on existing and future debt, or the forced exchange of debt for equity ownership of real economic assets.

Or all three.

The cycle of debt deflation is just getting rolling. The banks were only the first bailout and already the federal deficits are ballooning unsustainably. What will be the recourse when municipalities and states face default through catastrophic tax and revenue shortfalls? What will be the recourse when large commercial employers, industries and infrastructure confront failure from collapsing consumption expenditure? What will be the consequence when unemployment, homelessness, political disaffection and crime are resurgent and threaten the political fabric?

We are at the end of the beginning. Hank Paulson has played a clever game for the past decade of exporting dodgy paper to the US creditors abroad while forcing a middle class subsidy of the tax exempt corporatists at home. Now he plays a clever game of devaluing all currency and paper assets, exporting the pain to foreign taxpayers and investors. But this is not a game that America can win without the debasement of everything America once represented as holding value in its formerly prosperous market economy.

In my experience, there is nothing so permanent as a temporary expedient. It is hard to see how partially nationlised banks will ever be more than the means of political redistribution of wealth and power, and so corrupt both the economy and political system.

We had to burn the village to save it.

Perhaps someday we will hear a remorseful Mr Paulson or Mr Brown echo Robert McNamara, early architect and aggressive propagator of the Vietnam War: “We were wrong, terribly wrong.”

________________________

I will be out of touch for most of the next nine days, but will check in as and when I can. There may be a guest blogger here next Friday who I’m confident will be enthusiastically received, if he accepts.

London Banker:What you are saying is dire indeed. You are, of course, speaking in larger terms, but in terms of everday reality, what can I do as an individual trying to protect my hard earned assests (which have been saved thus far due to Dr. Roubini’s generosity in sharing his knowledge with all who will listen) and to protect my family, friends, community? What will you do?

Sean October 17, 2008 at 1:01 pm

The other blogger … would you please invite MISS AMERICA or Rich …. He is the ONE OF THE BEST in market timing, from stocks to commodities!

interested reader October 17, 2008 at 1:17 pm

Always to the point. Thanks for your insights.

Guest October 17, 2008 at 1:47 pm

LB you seem to be converging with Shiff and some of the gold bugs, much to my disappointment. The links I have provided for feedback over the last few months were in hopes of those such as you, would redirect my concerns to a less “scary” outcome. Because I greatly value your mind, I am disappointed not in you, but our likely outcome.Thanks for all you provide!Please feel free to respond to my question for MA on the Professors blog datedBy Guest on 2008-10-17 12:57:28″Do you see any long term (1-2years) massive inflation? Deflation would seem to increase the relative size of our debt thus increasing the likelihood of default. Perhaps this is why buffet calls for buying stocks and getting out of cash? Any thoughts on how to realistically solve our long term debt problems without inflation?’hlowe

DocBerg October 17, 2008 at 1:57 pm

Might it be possible for RGE to keep a more prominently displayed link to London Banker’s essays? They seem to disappear into the void almost immediately, and this is a sad situation for those of us who greatly value his commentary.

Guest October 17, 2008 at 5:09 pm

Agreed – I found it only by doing a search and even then it was difficult

Hi London Banker.I just read that article on Deflationary Debt and Depression. A few commentsHe lists as step #2 “Money interest on safe loans falls; money interest on unsafe loans rises.” Is this not what happens when nice little 30 year mortgages to people with good credit scores are around 5.5% (but most of them already have houses so there’s not too much to make of them) and people with bad credit scores have to pay more because they are less likely to payback but the government encourages loans to these borrowers anyway (You had me at the Community Reinvestment Act..).And this is only # 2. on his list.One of the last ones on his list is lending dries up, banks fail.Scary stuff. Are you now saying we’re just past the point of no return because there’s not enough $ to bail out the banks and simply trying to do so will mean nobody will finance the US government for anything in the future?As a bureaucrat I’d love to know; can I expect my whole future to be furloughed? Should I start learning how to speak Chinese? Are there any fields of employment that might be safe?

Mark October 17, 2008 at 2:24 pm

LB, are you now throwing your arms up?I believe that the flaws inherent in this system are finally coming to fore. There are no fixes.The question facing us now is: How are we to address resource allocation?The same people who have hoarded vast sums of wealth are the same ones who will be proposing the next solution. If they don’t have a come-to-Jesus moment it’s going to get really ugly…

Anonymous October 18, 2008 at 12:45 am

aaahh, mark, we in the USCo just had a CEO for the past 8 years that had a come-to-jesus moment a while back already.another question facing us now: how do we stop having our lives controlled by those who hoard vast sums of wealth?it got boring about 2 lifetimes ago.it’s getting tedious now.perhaps the answer lies in the answer to your question above.time to get out of the box and start thinking with our imagination…

Guest October 17, 2008 at 2:24 pm

Really I dont get it. You call out the bankers and their underhanded ways at manipulating the system to enrich themselves at the expense of the masses yet you call yourself London Banker. Perhaps you should consider a using a different call name, that is of course assuming that your not one of them.

Mark October 17, 2008 at 2:34 pm

Bankers are human. You are a human. Therefore, you too should perhaps change your name (or specie)?Nothing is 100%. Just like there is always a few bad apples, in banking there’s likely to be a few good ones!

Lord Sidcup October 17, 2008 at 4:54 pm

The problem is the overall system (the behaviours required of bankers etc) which makes questions of individual goodness or badness irrelevant.

Lord Sidcup October 17, 2008 at 5:02 pm

This should clarify your query of London Banker’s role/titlehttp://www.rgemonitor.com/financemarkets-monitor/253222/fishers_debt-deflation_theory_of_great_depressions_and_a_possible_revision

Michael Khor October 17, 2008 at 4:21 pm

LB, the thing that intrigues me is that you have frequently highlighted bankers’ flawed greedy attitudes and manipulations, yet you are one of those elite. How do I reconcile that? Nevertheless, I admire your insightful commentaries that enable most of us to think more critically about the government and policy makers’ actions. Sadly, the USA has declined from being a model of free market capitalism to being a model of crony capitalism coupled with policies opacity. Surprising, not much the Administration missteps have been debated in the mainstream media. Maybe, that is due to journalistic patriotism, conflict of interests, etc.?Pertaining to you above commentary, LB, what is your advice to the prudent, frugal and honest Americans?

DocBerg October 18, 2008 at 11:27 am

Banking need not be a morally dubious and destructive business. The key to avoiding most of the pitfalls that have landed us in the current morass is fiduciary responsibility and magnanimity.The entity that can guide us to these virtues is morality, which generally, though imperfectly comes out of the teachings of revealed religion. Abandonment of teachings such as the 10 Commandments, and the Golden Rule directly leads to the Nietzschean Abyss. Most of the more traditional religions have similar codes of ethical behavior.Where Modernity has failed is in trying to substitute hopefully self-correcting institutions based on vices such as avarice and lust for power in place of these traditional moral codes. Most vices are inherently self limiting. Gluttony can only go so far, even in Roman banquets. Sloth has its physical limits, as does lust for sex. Avarice and lust for power, on the other hand have no physical limits. The former vice was celebrated by Locke, the latter by Hobbes. Since they have no limits, their pursuit inevitably leads to excess, which expands into hubris, and then falls victim to nemesis.With all due respect to free market fundamentalists, economic systems are no more self correcting over time than are political systems. Both wind up with abusive concentrations of power, and then collapse.My perception of the current difficulties is that they are essentially caused by a lack of trust between parties. This is a moral problem, and cannot be solved through amoral fiscal policies. Rules of behavior need to be established and enforced. This requires regulation from a mainly independent entity tasked as an impartial umpire. This harsh reality is resisted by aforesaid fundamentalists, but it is necessary. Both London Banker and Professor Roubini have been pilloried over supporting this, and unfairly so. The problem with any sort of regulation, whether imposed by a trade organization, professional group, or a government is that they tend to be captured by the malefactors. This is shown in the U.S. by the obvious merger of Goldman Sachs and the Federal government. Unless this cronyism is ended, the moral problem cannot be effectively addressed and the crisis ended.Where might we find the suitable people who can regulate the financial entities and do so with the overall public good as a goal? Honest bankers. Not all bankers are greedy cretins. Many bankers still wind up making fortunes honestly by helping their clients become wealthy. They achieve success by working for the benefit of others. The divorce of economics from ethics was a tragic mistake. Adam Smith was the Professor of Moral Philosophy there in Glasgow, and while he wrote a major work in economics, also did one on “Moral Sentiments.” So, how might we best reform our damaged financial institutions and install less corrupt oversight of them most effectively?

Lord Sidcup October 17, 2008 at 4:46 pm

Excellent stuff.

Tom October 19, 2008 at 11:18 pm

This is a helpful post. Fisher seems to be working towards an appropriate level of abstraction in this problem. By this I mean, say, in a physics/math problem you solve the equation independent of the actual numbers and derive a proof that applies to all the permutations within a given set of rules. This article steps towards finding those rules (though most of what I read obsesses on the specifics of our current situation, understandably I suppose). I am unfamiliar with the financial literature (though this site has made me realize how interesting it is, though it seems often ungrounded/unrigorous). Do you have any recs. for interesting reading? A lot of what I’ve come across is either very general or uses advanced mathematics to describe a useless host of assumptions (I do recognize this is a ridiculously difficult field to study without resorting to broad assumptions).Thanks for you writing, I enjoy reading it.

Unwelcome Guest October 20, 2008 at 5:28 pm

Tomlike you am ignorant of the realities of high-flying finance, but am very interested. I just read Nassim N Taleb’s two latest books, which make a very convincing argument that reality is too complex and markets too unpredictable for these mathematical abstractions to be of any use. In fact he claims they are extremely harmful.

Guest October 26, 2008 at 5:20 pm

dear allhaving been spared the worst of recent events, thanks to following blogs such as this, thru professional investing etc.. i feel a bit of despair on a general level. it seems no one is brave enough to put forward solutions that will help repair the mess we are in. ok, enough news on how bad earnings will be hit at XYZ & Co., or about the rising deficit in cuckoo-land, or how bad markets were creamed last friday etc etc.. how about making some decent forward-looking proposals, get the ball rolling and lets see if we can prove that the private sector is worthy enough to prevent a full-scale government balls-up bail-out…. anyway why are we letting governments sort out the mess.. its not like they got their own finances in order during the good times?as a former credit analyst, i can spend my life picking apart data showing me the systemic risks, the transmission mechanisms for default etc etc.. but whats the point.. we all know the bad news now.. even the Daily Mail and the Sunday Sport have cottoned onto where we are going economicallylets spend some of our hard-earned knowledge from our MBA, CFA, PhD or whatever qualifications we can boast of, to bring a long-term solution, raise confidence and encourage risk-taking and get us out of the mireas for RGE monitor.. this publication could set the standard for such a process, having been so eloquent at the onslaught of this current ‘crisis’ when many were in denial…. nows your chance to really shine, and lead us forwardand if you want incentives…look at it like this, i can’t make that much by going short anymore, but who knows where the right long positions could tally over the medium-termmarket valuations are based on expectations.. so lets give them a reason to expect something positive..i look forward to hearing from you